Environmental and Safety Issues

The three main trends in environmental regulation¹ in recent years have been: (a) a shift from command and control regulation towards economic instruments that provide incentives for operators to choose optimal investments in environmental protection; (b) an increasing availability of information on the monetary value of environmental costs and benefits; and (c) an increasing tendency for environmental objectives to be determined in international fora. In addition, interactions between environmental regulation and utility regulation have grown in importance. There are a number of important interactions between the economic and environmental regulation of these sectors:² (a) environmental regulations may be a critical determinant of investment programs; (b) the rate setting process may affect a regulated company’s incentives to respond to economic instruments; and (c) the economic regulator may be particularly well-placed to deal with certain sector specific environmental problems.

Despite the trend towards the use of economic incentives, there remains a predominance of command and control in environmental regulation in which the government establishes standards and a penalty system for enforcing the standards. Even command and control systems can operate as incentive systems because operators sometimes weigh the costs of compliance against the costs non-compliance in making their production decisions. As a result, governments often carefully weigh the costs and benefits of environmental regulations to ensure that customers and citizens receive a net benefit from the regulations. The regulator may be involved in this cost-benefit analysis because of the regulator’s expertise in understanding operator costs.

The interactions between economic and environmental regulation raise several issues. For example, they raise the question as to whether the economic and environmental regulation of the water and energy sectors should be institutionally integrated.³ Also, regulatory policies for rate setting affect the operator’s incentives in complying with environmental regulations.⁴ One option for dealing with externalities in rate setting is to allow full pass through of externality charges. However, this reduces the operator’s incentives to reduce its creation of externalities. Another option is for the regulator to forecast the cost of controlling the externality and to adjust the price-cap accordingly.⁵ A third approach would be to allow partial pass through of the externality cost.⁶ In some cases, the regulator may be able to shift the externality charge on to the users, rather than to the operator. This might be appropriate if customer demand is the primary driver of the externality and the operator cannot affect the amount of the externality nor its cost.

Footnotes

1. See Environmental and Safety Issues.
2. See Common Roles of Regulators, and sections on Identifying Information Requirements and Measures to Improve Data Quality of Financial Analysis for information on roles for utility regulators and relationships with other government agencies.
3. See Common Roles of Regulators and Identifying Information Requirements for information on roles of regulators and the scope of regulatory institutions.
4. See Price Level Regulation for information on regulating the overall price level and Tariff Design for information on price design.
5. See Price Regulation for details on price cap regulation.
6. See Principles in Price Level Regulation for information on other cost pass-through issues.